What is Permanent Income Hypothesis?
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The Permanent Income Hypothesis (PIH) is an economic theory proposed by economist Milton Friedman. This hypothesis posits that consumers' consumption decisions are primarily based on their long-term expected income (permanent income) rather than current short-term income fluctuations. According to the PIH, consumers use savings and borrowing to smooth their consumption levels over time, making their consumption patterns more stable despite short-term income variations.Key characteristics of the Permanent Income Hypothesis include:Long-Term Perspective: Consumers' consumption decisions are based on their expectations of long-term income rather than short-term income changes.Consumption Smoothing: Consumers try to maintain a stable level of consumption by saving during high-income periods and borrowing during low-income periods.Savings and Borrowing: When income is high, consumers increase savings; when income is low, they borrow to maintain stable consumption levels.Income Classification: Income is divided into permanent income (long-term sustainable income) and transitory income (short-term income fluctuations).Example of the Permanent Income Hypothesis application:Suppose an individual expects their long-term income (permanent income) to be $50,000 per year, but in a particular year, due to bonuses and other short-term factors, their income reaches $70,000. According to the PIH, the individual will not significantly increase their consumption but will save the additional $20,000 to use in future years when their income might fall below $50,000, thereby maintaining stable consumption.
